Speech by SEC Commissioner:
Remarks before the California '40 Acts Institute
by
Paul S. Atkins
Commissioner
U.S. Securities and Exchange Commission
San Francisco, CA
April 27, 2005
Thank you, David, for that kind introduction and for the opportunity to join you today. Of course, my sons were disappointed that you scheduled this speech for today, instead of tomorrow, which is "Take your Sons and Daughters to Work Day." No cable car rides for them this time.
Today, I would like to talk broadly about some of the issues that we at the Commission have been thinking about lately. Then I would like to talk a little more specifically about some compliance issues. Before I begin, I must remind you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
It is always helpful for me to learn the views of those who live and practice outside of Washington, D.C. After all, as President Eisenhower said, "Farming looks mighty easy when your plow is a pencil and you're a thousand miles from the corn field." So, it is necessary to visit the corn field once in a while to see what is really happening.
An aversion for finding out how our actions actually affect people on the ground seems to have colored a number of recent Commission actions. These actions have drawn criticism from inside and outside the Commission. Two weeks ago, the Commission found itself in court defending the fund governance changes that we adopted on a 3-2 vote last year. The challengers charged that the Commission had determined to mandate enhanced independence requirements for funds without considering whether those requirements would even address the problems that were cited as a reason for the rulemaking. We relied on our "intent" to protect investors as our primary rationale.
This is not the only recent instance in which we have stated that a rule is intended to achieve certain goals without explaining how the rule will work to achieve those goals. Remind me, where leadeth the road that is paved with good intentions? Rather than focusing solely on intentions, policymakers should look at results and figure out the optimal path to achieve the desired results - with the least cost and disruption.
Earlier this month, the Commission, in another 3-2 vote, approved far-reaching changes to market structure, again without regard for cost or disruption. I am referring to Regulation NMS, which, although clothed in noble-sounding objectives, is rooted in fundamental misperceptions about how the marketplace actually functions. If our rules serve only as an anti-competitive shield for existing market players, or serve to chosoe winners and losers, then the investor certainly loses.
As the business events of the past few days demonstrate, the marketplace moves on despite our regulatory action. Business combinations of the sort recently announced have long been expected - certainly since fierce competition between electronic markets slashed transaction costs and decimalization upended business models. Rationalization of the marketplace was inevitable - only the identity of the eventual pairings was the subject of fervent speculation. If anything, the uncertainly caused by the Commission's zigs and zags regarding market structure over the past year or two and the existence of the anti-competitive ITS trade-through rule may have postponed these transactions. Who wants to commit billions of dollars of capital without an idea of what the government may come up with next? A government that acts unpredictably inevitably increases costs for businesses and investors. If these business transactions were grounded solely on the arbitrary rules that we approved, without something more fundamental driving them, then I would really be worried about the soundness of the United States capital markets.
Commission-level philosophical debates aside, much of the real impact of our rules is determined by implementation. The Commission staff, of course, makes many of the implementation decisions. The Commission benefits from being able to delegate complex questions of implementation to a talented and experienced staff, who can deal with matters more quickly than we can. But, absent limits on delegation, implementation decisions become de facto policy decisions. The staff's decision-making process is not generally subject to public scrutiny. Policy decisions should be made by the Commission in accordance with the Administrative Procedure Act, which allows sufficient, formalized opportunities for public scrutiny and input from all affected parties. We should resist the temptation, for example, for staff no-action letters, rather than Commission rules, to form the basis for widespread industry practices.
For example, in the Regulation NMS rulemaking, the Commission explicitly punted many determinations to the no-action process. For example, Regulation NMS will dramatically affect electronic block trading systems. The staff has been talking to and studying these markets for the past two years to understand their business and consider issues that arise from their business model. But, rather than provide for them in Regulation NMS, say through explicit exemption or other accommodation from the trade-through rule, the Commission majority left the issues open for the staff to address through the no-action process. That is an amazing abdication of responsibility, particularly because it is anyone's guess how the staff will come out on the issues.
This is just one of many areas in which the Commission has implicitly or explicitly delegated policy decisions to the staff. Other areas include the issuance of staff accounting guidance, which often is determinative in deciding the fate of huge financings and mergers and acquisitions. In particular, so-called "staff accounting bulletins" have all the trappings of rules, yet are not subject at all to the benefit of public notice and comment. In the area of enforcement, the Commission has ceded a great deal of control over the settlement of even the largest enforcement actions.
It is tempting for the Commission to turn matters entirely over to the staff, particularly matters that are highly technical. But, because the devil is often in the details, we need to restrain this impulse as much as possible.
For practical reasons, the Commission appropriately leaves the day-to-day task of overseeing registrants in the hands of our staff. This is a big job. Even with the approximately 500 examiners dedicated to investment advisers and investment companies, the staff finds itself in a constant battle to keep up with the growing number of funds and advisers that it oversees.
The new risk-based approach to examinations, using targeted exams and mini-sweeps, is an attempt to allocate our compliance resources more wisely. Anecdotal reports suggest that some refinements will be necessary before this new approach to examinations produces the results that we anticipated. Even allegedly targeted examinations can last for months. I have heard anecdotes about firms receiving essentially simultaneous, overlapping document requests from multiple regional offices of the Commission. These document requests can be lengthy and the technology needed to comply with them can be expensive. We must ensure that the right hand knows what the left hand is doing.
Our staff has focused increasingly on emails and other electronic messages, which can provide important insight into what is going on at a firm. The intensified interest in email, however, has proven frustrating and costly for firms. Some firms have complained that the staff's email requests go beyond the scope of the records that the rules require them to keep. Even if firms have copies of the requested emails, they incur substantial costs in searching for and producing them within the deadlines set by the staff. These concrete costs might be dwarfed by lost efficiencies and impeded customer service if firms elect to stop or curtail email usage in order to avoid having the burden of complying with staff requests. Our staff needs to look at emails as part of its examinations, but we owe firms clear guidance on what electronic messages they need to keep, how they need to keep them, and how long they need to keep them.
Please let us know if things go badly during an exam. Our new exam hotline, 202-552-EXAM, or email ExamHotline@sec.gov, provides a safe way to lodge any complaints. I also invite you to call my office, 202-942-0700. I would be happy to hear your comments, as well.
I hope that the new compliance rule, by building up internal compliance programs at funds and advisers, will help to temper the need for, or at least the frequency of, disruptive Commission inquiries. Evidence that compliance issues are accorded adequate attention at a firm generally will lessen the need for intense scrutiny of that firm by our staff. A strong chief compliance officer, or "CCO", will play an essential role in ensuring that compliance is accorded appropriate attention. By simply ensuring that our staff knows whom to contact about compliance issues, the rule should bring speedier resolution of any concerns.
As Chairman Donaldson has noted, the CCO should not view himself as a deputy of the Commission.1 If a CCO viewed himself in this way, his effectiveness within his organization could be compromised. He might find himself no longer privy to much that goes on at his firm. Within weeks of the October 5 compliance date, our staff was calling CCOs at large advisers "to have an immediate and personal introduction."2 The introduction consisted of asking the new CCOs a series of questions about themselves and the status of their compliance programs. It is important for us to look at how funds and advisers are implementing the rule and to get a sense of who CCOs are.
Some questions, however, would be better left to boards to ask. Asking CCOs to identify any gaps in their compliance budgets, for example, might strengthen CCOs' leverage. But discussing such issues with the regulators could also heighten tensions between CCOs and business people at their firms and is unlikely to produce reliable information for the staff. What incentive would a CCO have to tell us that he would not find a larger budget and more employees helpful? As we establish our relationships with CCOs, who are understandably squeamish about the scope of their responsibility and liability, we need to keep in mind that they do not work for us.
We do anticipate, however, that we can work with CCOs to improve internal compliance. To this end, the Commission staff has recently embarked on an outreach program that is intended, through seminars and newsletters, to provide sought-after guidance and ease some of the concerns associated with the rule.
We must pair this program with a commitment not to employ a "gotcha" mentality. It may be unnecessary and counterproductive to penalize a firm that has identified a problem, notified us, and corrected the problem. Unfortunately, firms have no confidence that we will not penalize them in such instances. Last year, for example, the Commission imposed a $1 million penalty on a broker-dealer for recordkeeping violations and a related failure to supervise, even though the firm conducted an internal investigation in response to an employee complaint, disciplined the employees involved, and notified the Commission. If CCOs fear that every time they call us they will generate a compliance exam or enforcement referral, they will not be inclined to keep us in the loop.
Similarly, if CCOs fear that any compliance lapse will place them on a Commission blacklist, they will not be eager to serve. This was a big concern cited by many potential CCOs before the rule took effect. After having been on the job for six months, some CCOs are calling for higher pay, which suggests that they are still concerned about responsibility and liability. Particular concern stems from a footnote in the adopting release that stated that a person who fails to carry out his duties as CCO for one fund would be the subject of enhanced staff scrutiny if another fund board approved that person to serve as CCO.3 Undue emphasis should not be placed on this footnote; it would be surprising if our staff did not consider the CCO's track record, along with many other factors, when evaluating a compliance program.
Finally, we must keep a steady eye on whom we are trying to serve with all of these efforts. Investors, of course. So, we cannot lose sight of the fact that compliance efforts are not the end in and of itself. A good compliance structure is an important component of investor protection, but it comes at a cost. Investors pay for compliance efforts through lower returns on their investments. Not only do the employees and technology dedicated to compliance cost money, but there is an opportunity cost when employees' focus is diverted from their primary tasks.
The cost-benefit analysis of particular compliance measures is firm-specific. Measures that are essential for one firm may not be necessary or appropriate for another. The way in which small firms implement the compliance rule will vary considerably from how larger firms implement it. Some funds, for example, have outsourced the CCO function. Although our staff has questioned "whether rent a cop[s] could really be up to the task",4 an outside CCO may be the best option for some firms. Some firms may even decide on a combination. We cannot permit examination and enforcement activities to turn a flexible rule into an expansive, one-size-fits-all rule.
The compliance rule cannot be successfully and uniformly administered if our regulatory, compliance and enforcement staffs do not work together. Many have noted that interaction between and even within divisions is often engaged in only grudgingly and with mutual suspicion. This "silo mentality" management problem was highlighted more than two years ago in an internal report on the operations and resources of the Commission prepared at the request of then Chairman Pitt. We need to continue to make strides towards breaking down internal impediments to co-operation.
We should look back at our ten years of experience with a stand-alone Office of Compliance Inspections and Examinations to see if this is the most sensible model. Would it be easier for our staff to administer the compliance rule and other regulations consistently if we reintegrated examiners into the Divisions? An integrated structure could allow for improved interaction and exchange between the folks who write and interpret rules and those who are on the frontlines interacting with registrants and assessing their compliance with our rules. On the other hand, potential benefits from a stand-alone OCIE might weigh in favor of implementing more moderate measures to improve coordination between OCIE and the Divisions.
In closing, I hope that all of you, in providing counsel to funds and advisers, will work with them to build solid foundations for compliance with the securities laws and regulations. I also ask that you assist us at the Commission in identifying the issues that are of concern to people on the ground. Together we can achieve an industry-wide commitment to compliance without imposing on investors, whose dollars pay for compliance, unnecessary costs. I hope that we at the Commission can learn from watching what you do and commit ourselves to regulating in a manner that produces benefits for investors at least as great as the costs that it imposes upon them.
Thank you very much for your attention.
Endnotes
http://www.sec.gov/news/speech/spch042705psa.htm
